Thursday, November 13, 2014

Stocks vs. Real Estate - which will lead you to freedom?

About a month ago, I had the opportunity to hop onto the real estate bandwagon. It was a terrific deal, had low entry barriers and speculators had high expectations of the area where the project was located.

But I passed on the opportunity. (I hate passing on opportunities, especially when it is laced with the promise of financial freedom.)

Not because it was a bad deal, but it was a mixture of risk averseness, timing and lack of conviction on my part.

Well, it got me thinking. For someone on Forbes's Billionaire List who made his/her wealth through stocks, I can name you one who achieved the same through real estate.

But we're not talking about who makes the most wealth here, that's not the point. We're talking about financial freedom - that's what White Collar Freedom is all about.

So, Stocks or Real Estate?

REAL ESTATE

The case FOR real estate:

You make a profit through capital gain and rental yield. When a property increases in price and you sell at a higher price than your cost, you make a capital gain. When you charge a rental that is higher than your monthly mortgage payment, you earn additional monthly income. What's there not to like?

The ability to leverage with structured risk, as opposed to margin trading on stocks.

Deals & other sweeteners by developers. Over here where I am located, there are various deals and offers that can get you a 95% loan - which essentially means that your initial outlay is a mere 5% (or sometimes even lesser). Other sweeteners include guaranteed rental payments for the first 2 years. However, this differs from country to country.

Low initial outlay for potentially massive gains. Your outlay may only be $20,000 (5% of a $400,000 property) but if the value of the property increases to $500,000, you earn $100,000. That's a 500% return on investment!

Also, where I'm located, you only start paying your mortgage when the property is ready for occupancy. So if the project takes 2 years to complete, you pay nothing (besides down payment) for the first 2 years, which gives you:

More time to save up for a buffer. More financial buffer means you have more holding power when the rental market is soft. In simpler terms, it means you can sleep better at night.

Ability to refinance and bankroll another property with the difference. Do read up about refinancing.

The case AGAINST real estate:

You are assuming that property prices will alwaysgo up. It is also optimistic to think that you'll always have a tenant. But that's why you need a financial buffer (read point 5 above).

The risk of abandonment. Project developers may abandon the project due to financing issues or other reasons and you may lose your down payment. (This applies to unbuilt projects only)

Maintenance, insurance and legal documentations. There is certainly more hassle when it comes to real estate - stacks of legal documentations to secure your property, applying for financing, etc. Don't forget furnishing and maintenance of property units, as well as the collection of rental from tenants (however, this can be overcome by appointing a property manager at a fee, thus reducing your net income yield)

Lack of liquidity. Unlike stocks, you can't sell your property as and when you like. When times are good, you pay your monthly mortgage payments. When times are bad and your property is vacant, you still pay your monthly mortgage payments. If your financial buffer can't withstand a rough period, you run the risk of foreclosure and unlimited liability. (Worst case scenario = bankruptcy)

Physical survey and location study. The thing about real estate is that there is more work involved in the preliminary stage which requires you to travel to the location physically and understand the surrounding area and growth potential.

STOCKS

The case FOR stocks:

You make a profit through capital gain and dividends. Similar to real estate, you actually own a percentage of an actual business which you can sell off at a higher value if the price goes up. Companies with stable track records also pay out dividends that increase every year.

Low entry barriers. Stocks in the US are sold per unit while other international stocks are sold per lot (e.g. 1000 units). Generally, it is easy to open a brokerage account and start investing with $1000 as a start.

More strategies to choose from. If you're aggressive, you'll go for a growth model (purely on the idea of buying low & selling high). If you're passive, you can dollar-cost-average on Index Funds and Exchange Traded Funds (ETF). If you want a slower but steady growth strategy, you have dividend investing (only buying companies that pay increasing dividends for the past 10 years).

Limited liability. When you invest in stocks, you are using money that you already have. Therefore, you can only lose what you put out on the table.

High on the liquidity scale. Unlike real estate, if you need to cash out for whatever reason(s), you just have to hit a button on your computer and you get your cash in 1-2 days.

Easily available data and documentation. More data helps you to make a decision. Financial reports, ratios, management information, industry studies, etc.

Ease of transaction. With online brokerages these days, all you have to do is to hit a few buttons on your keyboard and a transaction is made.

You generally don't lose if you don't sell - requires little holding power. If you invest in high quality stocks, it doesn't matter if the price fluctuates, you have a choice to sell ONLY when the price is high. On the contrary, if the price of your real estate decreases and if you have no tenant, you continue to pay the monthly mortgages.

The case AGAINST stocks:

There is more temptation to time the market. Speculation is as good as gambling. If you're speculating, you might as well go for a game of roulettes.

Lack of leverage. With the exception of margin trading, investing using your own money means that there is no potential for huge gains like real estate. You're considered a skilled investor if you make 6-7% net returns per year (read: Bloomberg). However, with a dividend growth strategy, the magic of compounding works for you and this can accelerate the wealth building process significantly.

Final Thoughts:

The conclusion is fairly obvious to me.

If you have a a point of entry into real estate and you have holding power, real estate investing will build your wealth relatively faster than stocks.

But if you're just starting out and have no holding power, buying high quality stocks that pay out good dividends beats putting your money in a savings account, any time of the day.

You raised an interesting point. By leveraging via a company, I'm assuming that you are focusing on the benefit of a company being a separate legal entity with limited liability (pls correct me if I'm wrong).

Sounds possible theoretically, but if the company's sole activity is in investing and has no track record, would creditors still extend capital to that company? Besides, if the holding company is in financial services, I'd assume that its activities will be heavily scrutinised by the SEC.

An alternative would be to do it Berkshire Hathaway style, where the company initially has a core business (textile) and use it to own equities in other companies. This strengthens the case for getting loans from banks and other investors.

Then again, this would dilute the advantages of stocks (passive nature and requires no holding power) as compared to real estate.

Just my two cents...tell me what you think...

Btw, your Q x DYoc equation is an interesting way to filter out investments. Never thought of it that way.

I acquired some rental properties from my mom and sold them as quickly as possible. I know in the personal finance world, acquisition of rental property is almost like reaching Utopia but I found it to be a real pain in the butt that didn't pay nearly enough to compensate for the hassle involved. Without going into the late calls for repairs or the need to vet tenants, there are all kinds of costs that occur long before you get a penny of profit. With stocks/bonds all you do is pay a small commission and taxes on capital gains. I sleep much better at night with stocks and bonds.

Thanks for sharing your experience with real estate. Well, valid points there. There is undeniably more hassle involved with properties.

However, I'm assuming that the property that you owned was not in a location that has high rental demand? Regarding the maintenance of it, did you consider appointing a property manager (to manage the maintenance and collection of rental on your behalf)?

Would like to hear you share more on this...

I do fully agree that stocks can be a more passive option that offers a good night's rest.

The one argument here that weighs on me as a landlord is the amount of work required to maintain rental property is much higher, it's relatively passive at times, but not nearly as passive as owning stock. And the liquidity issue is huge too, there was a time where I wanted to sell my house to downsize and live alone but the market was horrible so I just ended up staying put.

Whole-heartedly agree with the hassle that is involved with real estate. Would the appointment of property managers be able to mitigate this?

The thing that I find interesting about real estate is not so much in rental income but in its ability to be flipped when the price appreciates even by as little as 10% after 1-2 years. (dependent on location of course)

Although the same can be said for stocks (via margin trading) the risk involved and interest rate for margin trading is higher I believe.

You are also totally right with the liquidity issue of real estate. I've heard the same from many people. Even if your property is valued at a high price, in a bad market, if it can't be sold, it is as good as a brick. Then again, you need to have holding power before you dabble in real estate.

Interesting analysis! Even more interesting is that I came to an entirely different conclusion.

For me real estate is the obvious loser for two simple reasons: (1) it's a lot of hassle managing rental properties and (2) you assume that housing prices are fairly valued at any given time.

In Belgium, for example, housing prices are insanely overvalued (mostly because of government subsidies and a cultural effect). An appartment will easily run you €200k + 10% taxes. The maximum rent you'll be able to get for such an appartment would be €1000 every month (very generous estimation). You'll have to substract taxes, maintenance, legal obligations, etc. In the end you'll have a €750 cashflow every month on that appartment.

It'll take you about 24 years to recover that investment (without a mortgage and not taking inflation into consideration). Considering there's not much room for price growth (nobody would be able to buy housing anymore), I believe the stock market will put me way ahead by that time.

NMW, you have a point about the assumption that housing prices are fairly valued at any given time.

This is also applicable to where I'm located where speculation has inflated the price of properties all over, causing most residential properties to be overvalued. The property bubble may burst soon - giving small time investors a chance to enter the market.

It's also interesting to know that the real estate market in Belgium has little room for price appreciation. Hmm, good to see that you have decided on a clear strategy (stocks) to achieve freedom.